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Tech Thoughts Newsletter – 28 April 2023.

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28 April 2023 - Our weekly market round-up with our public market team: Inge Heydorn, Partner; Jenny Hardy, Portfolio Manager; and Nejla-Selma Salkovic, Analyst. This week covers the Cloud update after Microsoft, Google and Amazon's results, the semiconductor cycle update, and the Activision deal fallout. Subscribe to our Tech Thoughts Newsletter for weekly updates on our latest news and insights.

Market: Earnings season is now in full swing and really was driving the most significant share price moves this week. Outside of tech earnings, the main take is that the consumer still seems to be holding up well, particularly in the US, so still question marks around the shape and timing of any recession remain. 

Portfolio: We added to Infineon during the week as we think that the noise around weaker Automotive demand for the second half, alongside price pressure is just that – noise. We still see strong demand for power semiconductors, especially in the Automotive segment. We think this will drive further upgrades for Infineon and that the consensus estimates for earnings will move higher. We trimmed our position in Activision after the negative ruling from UK Competition and Markets Authority as we now think there will be some time before we get some more clarity around the deal. 

All of Microsoft, Google, Amazon and Meta reported this week. Outside of their core businesses, the thing we were focused on is the amount of capex they are all spending around building out their own AI capabilities. They all need to spend, for different reasons – for Meta it’s about using AI to mitigate some of the advertising performance issues they had as a result of Apple’s privacy regulations; for Microsoft, AI leadership ensures they attract the next wave of new businesses into their software ecosystem. For each of Google, Microsoft and Amazon, selling Generative AI capabilities is one way they are trying to attract the next new growth customers to their cloud services. They are all in a race to invest, or risk falling behind. 

AI is costly – the servers that are used in training and inference have a huge amount more semiconductor content in them and are multiples the cost of standard enterprise servers. Meta alluded to capex going higher (it is already spending >$30bn this year); Google guided 2023 capex modestly higher than previously; and Amazon is shifting spend from its transport and logistics and adding more dollars to AI and LLMs. 

In the portfolio we benefit from the capex spend on servers and network infrastructure through the semiconductor content (CPUs and GPUs through AMD and Nvidia, both of whom make their chips at TSMC, and further down the chain benefitting the semi cap equipment companies which are all needed to make these leading chips). 

We think hyperscaler capex will amount to ~$160bn this year. And when we think about each of Google, Amazon and Microsoft – they are all in a position to continue to invest – all have large cash balances and an ability to sustain high levels of investment over time. 

Elsewhere, cost cutting continues to be a feature of most of the results we’re seeing – and tech overall is well placed to exercise cost control (typically high gross margins gives it a lot of flexibility in the cost structure) – that’s one of the ways we think tech can drive earnings growth materially higher than the market this year and one of the things which keeps us optimistic overall. 

The surprise of the week was the UK blocking Microsoft’s acquisition of Activision

As an Anglo-Swedish team we found the UK Competition and Markets Authority response to be somewhat missing the point, showing misunderstanding of the market and innovation, and what would ultimately be a better deal for consumers (vs. Sony’s dominance in consoles). 

More on that below and onto the detailed results: 

Microsoft the class act in AI – on the offensive and gaining share

  • Microsoft (owned) delivered a very good set of results, reporting revenue +10%, EPS +14%, with very little to pick holes in
  • Microsoft has spent this year on the front foot as it relates to AI, and the earnings call was no different, with Nadella alluding multiple times to the idea of gaining share. 
  • We think this is more than positive PR, and that Microsoft is genuinely benefitting from AI and its partnership with OpenAI, both in its core software business AND in Azure.  
  • In Azure, while the optimisation headwind we saw last year is continuing (Azure revenue has decelerated significantly over the past several quarters), that deceleration is slowing – and after AWS results last night we think Microsoft is gaining incremental dollar share – we estimate Microsoft will add ~$600m incremental Azure revenue this quarter vs. ~$300m for AWS. 
  • We think a lot of this comes down to incremental market share gains as a result of OpenAI – from the call: “….even Azure OpenAI API customers are all new, and the workload conversations, whether it’s B2C conversations in financial services or drug discovery on another side, these are all new workloads that we really were not in the game in the past, whereas we now are”
  • Companies using OpenAI are by extension using Azure  – that means that Microsoft is gaining incremental customers 
  • Microsoft 365 is doing incredibly well – and is an area we think is/will additionally benefit from the ability to upsell AI features and capabilities – Office commercial and Office consumer are both accelerating from last quarter, helped by more users moving to higher ARPU E5 products
  • The other big positive delta in the individual business lines was actually around a better than expected PC market, bad but not as bad… with signs of a bottoming –  Windows OEM revenue decreased 28% vs 39% last quarter (the market was expecting it to decline in the mid 30s). 
  • It still represents a very rough end market but it is getting better, and we do think inventory has largely cleared
  • On the UK CMA blocking Microsoft’s acquisition of Activision, the key to the decision was that the CMA defined the market to be cloud gaming (specifically separate from the console gaming market) – and because Microsoft is the largest player in cloud gaming it should be prevented from acquiring important gaming content like Call of Duty, which it would only offer on its own cloud gaming platform.
  • Of course, Microsoft would still offer Call of Duty for sale as it already is in the traditional console universe – so Playstation users could still play it as they can already – there is no way Microsoft would stop selling it on Playstation’s platform, because it would make no economic sense for them to do that. 
  • The issue is that the CMA is deciding to effectively say that streaming is its own market that isn’t competitive with the console market, which is of course not the case. Cloud streaming is an alternative to console streaming and buying the game outright. 
  • It means that cloud streaming is a market that will potentially be killed before it even gets going. 
  • Separately but staying on regulation, Microsoft has stopped bundling Teams with Office 365 after a complaint by rival slack which claimed Microsoft’s practice of bundling the two services was anti-competitive. 
  • Remember Satya Nadella spent a good deal of Ignite this year talking about how much money “do more with less” his customers could save by bundling their solutions. 
  • It’s not clear what measures Microsoft will take (will it have to charge separately for Teams or will having to download it separately be enough for the EU?). Regulation is always on the agenda for tech, so nothing really new here. 

Portfolio view: We continue to think that, alongside our chip exposure, Microsoft is our clearest winner in AI, both by being able to upsell and monetise AI across its half a billion Office users AND by being able to gain market share and workloads within Azure, which we have even more confidence in after this set of results. Microsoft is really the first company of scale to genuinely have AI products which are being bought by users, not only benefiting from increased ARPUs but also by attracting new users (forever the challenge for Microsoft’s incumbent position).

On Activision Blizzard (owned) we continue to think that, with or without the deal, the company is well positioned in the gaming market. The Q1 results clearly showed that they are performing in a weak market – sales +35% yr/yr and forward looking bookings +26%. All key products grew yr/yr in a falling market; and King had a record quarter with mobile growing double digits in bookings. The release of Diablo IV in 2Q looks strong as pre-sales have been high. All metrics including profitability and cash flow (which we focus on in the portfolio) were very strong, well above market consensus expectations.

Alphabet relief around search and YouTube; still a leader in AI

  • Alphabet (owned) – reported a slight beat on revenue and EPS. 
  • Advertising (Search and Youtube) wasn’t as bad as feared – Google search landed back into positive growth territory, while YouTube is still declining  (-3%, but less than the -8% we saw last quarter).Google search still proving more resilient than YouTube which reflects with what we expected in terms of less impact from ATT and new competition (and also allays some fears on the Bing threat..) 
  • Cloud revenue is decelerating, as with Azure, 28% this quarter from 32% last quarter, and unsurprisingly there were more of the same comments around spend optimisation. 
  • On AI, after all the blunders we’ve seen this year, Google was keen to reassure the market that AI is a core capability and something they’ve been investing in for a long time – we agree with that and as we’ve said before, we’re much less worried than the market about the threat to Google’s core business. 
  • From the call: First, Google AI. I’ve said before, AI has long been an important driver of our business. Advancements are powering our ability to help businesses, big and small, respond in real time to rapidly changing market and consumer shifts and deliver measurable ROI when it’s needed most. In Q1, we continue to innovate across our products. Take Core Search, for example. In targeting, we updated search keyword relevance using the latest natural language AI from MUM models to improve the relevance and performance of shown ads when there are multiple overlapping keywords eligible for an auction.
  • The way Google can use AI in its core business, in a way which doesn’t destroy the profit pool of search (ie. by applying a large language model to every query), is to make its advertisers campaigns more effective, in terms of bidding and the search ads shown. It means that, in addition to being able to sell its AI capabilities through Google Cloud, Google can benefit via reinforcing competitive advantages around its search business. 

Portfolio view: We continue to think Google’s position in search is strong, and its ability to use AI to reinforce competitive advantages around its core advertising business will continue to allow it to sustain high levels of returns. We also think there is probably more upside around margins to come and continue to hold it as a core position within our portfolio. 

Amazon – better retail performance; advertising a positive surprise, but signs of share losses in cloud

  • Amazon (owned) beat forecasts. There are always lots of moving parts in this set of results, but the focus on the call was around its cloud business: 
  • AWS grew 16% yr/yr, slowing from 20% last quarter, and slowing still further in April (~11%). When we look at the relative performance of the cloud names, we think it’s not just the law of large numbers which is slowing Amazon’s growth as the largest player: we think Microsoft is starting to take meaningful share (likely helped by its OpenAI partnership). As we commented for Microsoft, whereas AWS was the obvious cloud partner 2 years ago, now, with Microsoft’s relationship with the flagship OpenAI, they might be starting to be the cloud services platform of choice for new businesses
  • On the forward guidance numbers given we think Microsoft will add about double the dollar value in the next quarter ($600m vs ~$300m for Amazon). 
  • Amazon’s AWS business makes all (and more) of its total operating profit, effectively financing the still loss making ecommerce business. Going back to our comments at the start, we think it will force Amazon to continue to invest in building its AI capabilities.
  • The core retail business was better – again speaking to continued (surprising) strength in the consumer, particularly in the US. 
  • On the margin side, as with many players in tech, cost cutting is helping margin expansion and earnings growth
  • The standout impressive part of Amazon’s results was for us its advertising business +23% yr/yr beat all of the digital advertising players by a mile, and is now a $10bn/quarter business (and presumably very profitable..)

Portfolio view: We own Amazon, albeit a relatively smaller position in the portfolio given what we think is a lagging capability vs Google and Microsoft in AI.

Zuckerberg’s momentous pivot delivering

  • Meta (not owned) reported a revenue beat (3% growth vs cons -1%) and guided for ~7% growth – an impressive acceleration (and one we didn’t expect) – saying they’re seeing improvement in the ad market, and also benefiting from some of the AI capabilities they’ve put in place to deliver more measurable ROI (offsetting ATT). 
  • They’re also using AI to support engagement: Since we launched Reels, AI recommendations have driven a more than 24% increase in time spent on Instagram. Our AI work is also improving monetization. Reels monetization efficiency is up over 30% on Instagram and over 40% on Facebook quarter-over-quarter. 
  • Cost guidance coming down again – all the tech companies have that as a lever to drive earnings this year, Meta probably pulling the lever the hardest right now. 
  • While opex costs are being reduced, Meta is keeping its capex guide, which speaks to the necessity to spend: We expect capital expenditures to be in the range of $30-33 billion, unchanged from our prior estimate. This outlook reflects our ongoing build out of AI capacity to support ads, Feed and Reels, along with an increased investment in capacity for our generative AI initiatives. 

Portfolio view: We don’t own Meta, given the structural challenges around the top line and competition in digital advertising, although we do recognise an impressive return to growth and Zuckerberg’s focus on margins (and pivot from the free for all spend on the Metaverse last year…

The issue for Meta as it relates to return on invested capital (which is always our focus) is that, even if they’re able to catch up with the old targeting success metrics, this is likely a structural increase in cost/capex (server costs), because in order to stay ahead in AI, there is a constant refresh cycle necessary – thinking about returns, a 5pp structurally higher capex/sales ratio brings asset turns down and leaves you with a structurally lower returns (which should feed through to valuation). 

Digital advertising weakness outside the core players 

  • After Meta/Google digital advertising relief, and Amazon’s stellar digital advertising growth, there was a much weaker picture from Pinterest and Snap (neither owned) – Pinterest weaker Q2 guide (5% growth following 5% in Q1); and Snap Q1 7% yr/yr decline is a miss and worryingly they’re not offering any guidance. We don’t either and see mostly headwinds in the digital advertising space this year

Intel are losing share in datacentre, but signalling a bottom of the PC market 

  • Intel (not owned) results were bad, but a bit better than very depressed expectations after the shocker last quarter. Revenue and EPS beat in the quarter, though with revenue down 36% yr/yr this is still not a happy story – PC still a rough market but, like Microsoft’s OEM revenue, we do seem to be bouncing around the bottom/trough of the market. 
  • Q2 revenue guide was a bit better too, but EPS is worse – they’re having to spend more to try to stand any chance of keeping up with competition (as we’ve said before it’s really do or die for Intel to try to close back the gap and to try to pull in product roadmaps. That is happening but it’s costing them in opex and margin.  
  • Gross margin is still in the doldrums – 37.5% (where Intel used to be comfortably in the 60s – that all speaks to lower utilisation, lower demand for its products and we think, share losses)
  • On the call CEO Pat Gelsinger spoke to PC inventory correction largely being done (datacentre a little further behind) and a better second half – really reflecting what we’ve heard elsewhere in the chip sector. 
  • We think Intel continues to lose share to AMD in the server space, and that the H2 rebound Intel are expecting is less obvious… 
  • For us interesting is the capex number reported in the cash flow (they are the second biggest spender in semicap) – they spent $7.4bn in Q1 from $4.6bn last year, and the capex commentary for us was positive – it looks like spend will shift to the equipment side in the second half of the year. 

Portfolio View: We think AMD (which is own) is continuing to gain share in datacentre, particularly within the new bucket of AI spend. Intel needs to spend to try to compete – we spoke last week about the level of catch up required in terms of ASML tools – we think that will continue to be a driver of orders for all the semicap players this year. 

In semis, auto and industrial still showing resilience 

  • Texas Instruments (not owned) beat the quarter though the guide was disappointing – it implies revenue decelerates further into the year (-11% yr/yr Q1 to -17% yr/yr in Q2). We don’t own it as they still have reasonable personal electronics exposure where while inventories are starting to look better, we still see a bit of a risk and visibility into China is hard. 
  • However it is good readacross for our semis and the positive comment for us and IFX/NXP in the release: “During the quarter we experienced weakness across our end markets with the exception of automotive, as expected.”
  • STMicro (not owned) also reported – slightly better results and guidance. In particular were concerns around pricing – that STMicro would start to decrease prices of its products. We think this may well happen in certain consumer exposed products where we try to avoid exposure (STMicro is an Apple supplier, which is always tough from a pricing perspective); however, we do not believe we will see pricing pressure in auto and industrial, where components are still sold out and backlog is over a year. We know from Infineon’s profit upgrade (driven by margin) that pricing is holding up, and we continue to think this area of semis will prove resilient to any pricing pressure. 
  • UMC (Taiwanese foundry – a “little brother” of TSMC at trailing edge nodes) also reported largely better results and guidance and is another good read-across for the pricing debate. It is showing no signs of price cuts and utilisation is recovering to over 90%..

Portfolio view: We’ve been adding to Infineon around some of the market concerns on pricing, which we believe will continue to be resilient given the strong structural content growth. Infineon and NXP will both report next week

Memory market – benefitting from content increases around AI, utilisation starting to have the desired effect

  • Samsung and SK Hynix (neither owned) both reported this week – both with record operating losses (Samsung just above positive at a consolidated profit level but with heavy losses in memory) around DRAM price declines
  • Both spoke to the market at or near the bottom though we think both will continue to show losses in their memory business into next year. 
  • None of this is new or unexpected – memory has been in the worst downturn for over a decade, with writedowns and negative pricing creating a period of record operating losses for all players. Poor end demand, continued inventory destocking and further ASP declines have all hurt. 
  • The positive drivers looking ahead to Q2 and beyond are a lower level of price deterioration as the impacts from industry-wide supply cuts start to materialise, and the hope of a new server cycle and higher priced DDR5 and high bandwidth memory (which is required in servers used in generative AI – interestingly in HBM Samsung, which has always been the tech leader in DRAM, seems to be significantly lagging Hynix)
  • That’s alongside a sooner than expected recovery in PC and smartphone, given the more normal inventory situation
  • We do expect AI demand to be a meaningful driver of memory bit growth over time – the DRAM and High bandwidth memory content in AI training and inference servers are multiples of traditional enterprise servers –  but we’re still at the early stages of that build out. 
  • The industry wide supply cuts should start to feed through to ASPs from Q2, though we expect all players could still report a similar level of losses. 
  • Samsung gave colour on its capex for this year – expecting it to stay at a similar level as last year – positive for semicap names where a cut had been anticipated. 

Portfolio view: We don’t invest in memory players – while we do believe that the build out of generative AI infrastructure will result in meaningful bit growth for the memory industry as a result of the DRAM content growth per server, the reality is that the industry relies on rational supply, which can very easily break down, and has always struggled to make a sustainable return – just as we’re seeing now in the industry with the negative impact on pricing. We do think we should benefit from any memory recovery and the related bit growth through our semicap equipment exposure –  any stabilisation in DRAM ASPs is positive – historically a declining ASP environment has tended to lead to weaker memory spend – for our semicap names.

KLA and ASMI reporting in the semicap equipment space

  • KLA (owned) – reported revenue slightly better than the guide and the Q2 guidance a bit better too. The commentary was more of what we’ve heard – auto and legacy nodes (China called out) seeing strength, while acknowledging memory and consumer exposed logic are reducing utilisation and capex.
  • FCF $926m is impressive – 122% cash conversion – just as we saw with LAM Research last week these companies’ ability to execute cost control and cash generation in the face of an industry downturn is impressive and we think we’ll see it reflected across many of the businesses we own
  • ASMI (not owned) was more of the same – memory weakness continues and some push outs in leading edge foundry offset by strength in China spending on mature nodes. 

Portfolio view: We continue to like our semicap equipment exposure and the resilience the companies are showing in margins and free cash flow. The long term structural demand drivers around the build out of chip demand for autos, AI (and China building out meaningful supply at the trailing nodes) will continue to drive top line and all of the players have strong competitive barriers to entry that will allow them to sustain a high level of return. 

ServiceNow continues to deliver as the platform play 

  • ServiceNow (owned) – continues to deliver in enterprise software, reporting subscription revenues +27% yr/yr cc, and CRPO (a mroe forward looking metric +25% yr/yr). 
  • They very slightly nudged the guidance to the higher end of the previous range (now 23-23.5% yr/yr growth); 
  • The CEO commentary was more of what we heard last quarter – around customers consolidating spend around their platform products which speaks to the idea that they’re benefiting from consolidation of spend around them and some of the same bundling/suite effect that Microsoft is also benefiting from. 

Portfolio view: In software, we try to own the broader “platform” plays which can benefit from consolidation of spend. Longer term, we think the incumbent enterprise software businesses (like ServiceNow) are well placed to increase ARPUs through upsell of AI features and capabilities over time.

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